The euro puzzle

Vice-president of Analysis at Stratfor, Peter Zeihan, discusses important issues facing the euro zone with Colin Chapman

Colin: As leaders of the G20 countries prepare for their summit in France, the richest sovereign wealth funds like those of China, Abu Dhabi and Norway are being asked to risk billions of dollars of their surplus cash in the so-called grand plan to allay Europe’s debt crisis. But can that plan work?

Peter: No, this summit is basically a placeholder. None of the core issues in terms of a potential Greek default, a potential Italian catastrophe or banking crisis has really been addressed.

Colin: But will it be enough to keep the euro alive?

Peter: For at least the next few weeks until the next crisis. There were three elements of the plan that was agreed to at the late-night summit. The first plan was a bank recapitalisation of about ¤100 billion. Unfortunately, a third of that is specifically for Greece and that is before you consider any sort of Greek government write-down so you don’t have a lot of volume going into it. In fact, for countries like Austria and Belgium who have a couple of banks already in receivership, the entire amount of money for the recap is only to do with the specific banks. All of the broader problems of overcrediting, housing markets, pensions problems, none of those were addressed. You really need to do at least ¤300 or 400 billion recap if you are going to be very serious about this.

The second section was the Greek write-down of 50 per cent, which has been agreed to in principle but they have not figured exactly which bondholders are going to be having to do the write-down. Keep in mind that there is ¤400 billion in Greek government debt and only ¤100 billion of it is going to be released in some way. So you have got a considerable number of creditors out there who somehow are going to escape, and now they have got to figure out which ones are and which ones are not. That is going to be quite contentious; it is going to take a few weeks.

Colin: And then the third issue, of course, is the fund itself.

Peter: Right, the bailout mechanism, the European Financial Security Facility [EFSF] , they have agreed to put into place some sort of leveraging system, although they are going to be working the details of that out later. The problem, of course, with the leveraging system is it actually increases the chance of financial risk. What is necessary, if you are actually going to resolve the euro zone crisis, is you need state guarantees of a large enough volume that no one can bet against. Leverage systems are designed to be bet against.

Colin: All right, well let’s deal with those three points. First of all, let’s deal with the Greek one, because it is dependent, really, on a lot of private investors investing in Greece and losing their money, taking a 50 per cent haircut, which they had not expected. Are they going to agree to that?

Peter: Keep in mind that the banking sector in Europe is not nearly as independent as Anglo-America. You have got the states, who have the banks beholden to them; they are able to twist the arms of the bank executives and force them to do things they would otherwise not do. Banks are not willing to challenge the regulators, and so you probably will be able to get a significant buy-in that is voluntary, although not very voluntary. The problem is what you do, for example, about the debt that happens to be on the ECB [European Central Bank] books? What do you do about the debt is held by the pension system? What do you do about the debt that is being held by the Greek banks?

Any three problems there lead to a break in the ECB’s credibility, greater pension responsibility for the Greek state or greater bank recapitalisation need for the Greek banks, all of which eventually falls back into the bailout needs. And so they have not really cut the needs of the Greek state to finance, they have just moved around the specific responsibilities. The headline number is the same.

Colin: Two things about the banks. First of all would be further stress tests, but stress tests so far have been a bit of a joke, haven’t they? Why should we think that they are going to be any different next time? And then secondly, what about the deleveraging that is inevitably going to occur as a result of this, which will actually make it harder for people to borrow money, which will slow the European economy, which is not what really is intended?

Peter: There is a bit of good news in this. ¤100 billion recap is a step in the right direction. Moving up to a capital adequacy ratio of 90 per cent is actually a very strong move in the right direction. It is vastly overdue, probably by five years. It is not yet anywhere near as far as they need to go, but at least there has been a step in the right direction.

The problem is that this is a bank recap that is entirely driven by the needs of the write-down. In fact, a write-down of the Greek debt is expected to cost the banks about ¤100 billion. That is exactly the same value of the recap, and now states are going to have to find ways outside of Greece in order to make up the difference and that is definitely going to cost them the ability to make loans. In fact, a couple of the restrictions that were put on the banks as conditions of the recap were no bonuses and no dividends. That might sound reasonable until you think that this is going to require the banks to raise money but not to promise any dividends. It is one of those things that sound great in principle, but in practice, unfortunately, do not work out very well.

Colin: And then coming to the issue of getting this fund up to ¤1,000 billion. As we approach the G20 meeting in Cannes, there is talk that they should put pressure on sovereign wealth funds to divvy up a lot of this fair cash and risk it in this great enterprise, and there are rumors that China may be thinking about this. But it is a big step, isn’t it? Why should rich countries just throw their money into this in the hope that they might get something out of it?

Peter: Well first things first. The countries that they are going to, for the most part, are not rich. Of all places that Klaus Regling, director of the EFSF, is going to visit in the next few days, Japan is the only one that I would actually consider to be rich. A lot of the other states do have considerable currency reserves but they are not wealthy states.

Regling is in China right now, and his initial talks with the Chinese about tapping their currency reserves have not gone well. The Chinese were polite, they received him, they listened to what he had to say, but there were absolutely no promises of new money. Regling says that about 40 per cent of EFSF bonds that have been issued at this point have been purchased by East Asian investors, but keep in mind that it is with a 100 per cent sovereign guarantee. With the direction that the Europeans are taking this leveraging question, at most the sovereign guarantee is going to be 25 per cent. And so the Chinese, the Japanese and anyone else who thinks they have a vested interest in the success of Europe have to be asking why I would put my money into a system that the Europeans are not willing to back.

Colin: And why would they put money in the system when they have a billion (or more, in the case of China) poor, who look at this and say why are they spending their money on Europe? Why aren’t they spending it on us?

Peter: Well, the Chinese do not have to worry about elections, so the dissatisfaction of people in the countryside is probably not a major concern for the Politburo. But remember for the Politburo, their currency reserves are their rainy day fund. That is what they use when their system starts to crack and fall apart. It is difficult to see them putting more emphasis on Europe than they put on themselves.

Colin: Quick question before we close about the politics of all of this because Bild, which is a very popular German newspaper bought by the masses, has a big headline, “Celebrate Merkel,” as if this is a great triumph for her. Well yes, she has pushed her will through over people like Sarkozy, but it is not yet a triumph, is it?

Peter: The euro zone has not been saved, this is not even more than baby step on the road to saving Europe. But let’s go back a few years. As recently as 2003 the French were still calling all of the shots in Europe. It was not until this chancellorship that we have actually had our first post-reunification government that has no ties to the pre-unification years. That is only two years old, and now for the last three European summits of substance Merkel has come in with a plan that everybody else has disagreed with, and yet she has managed to push it through anyway. That is where the EFSF came from, that is where the changes in the EFSF came from, and that is where this summit came from. And what the Bundestag approved on the day of the summit, and what Merkel took with her to the summit, is what eventually became the European plan. So leaving aside the issue of whether it will work, Germany is in charge. And Bild is right, celebrate.

Colin: Great, thanks Peter very much. Peter Zeihan there, ending Agenda for this week. I’m Colin Chapman, thanks for being with us. Bye for now.

Reprinted with permission from www.stratfor.com